Question

Required information

The Foundational 15 [LO10-1, LO10-2]

[The following information applies to the questions displayed below.]

Westerville Company reported the following results from last year’s operations:

Sales	$	1,000,000
Variable expenses		300,000
Contribution margin		700,000
Fixed expenses		500,000
Net operating income	$	200,000
Average operating assets	$	625,000

At the beginning of this year, the company has a $120,000 investment opportunity with the following cost and revenue characteristics:

Sales	$	200,000
Contribution margin ratio		60	% of sales
Fixed expenses	$	90,000

The company’s minimum required rate of return is 15%.

Foundational 10-13

13. If the company pursues the investment opportunity and otherwise performs the same as last year, what residual income will it earn this year?

14. If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-a. Assume that the contribution margin ratio of the investment opportunity was 50% instead of 60%. If Westerville’s chief executive officer will earn a bonus only if her residual income from this year exceeds her residual income from last year, would she pursue the investment opportunity?

• Yes

• No

15-b. Would the owners of the company want her to pursue the investment opportunity?

• Yes

• No

Answer 1

	Westerville Company
	Residual Income=Net operating Income-Average operating Assets*Required Rate of return
		Residual Income
		Last Year	Investment Opportunity	Total
	Sales	$ 10,00,000.00	$   2,00,000.00	$ 12,00,000.00
	Less: Variable Cost	$   3,00,000.00	$      80,000.00	$   3,80,000.00
	Contribution Margin	$   7,00,000.00	$   1,20,000.00	$   8,20,000.00
	Less: Fixed Cost	$   5,00,000.00	$      90,000.00	$   5,90,000.00
	Net Operating Income	$   2,00,000.00	$      30,000.00	$   2,30,000.00
	Average operating assets	$   6,25,000.00	$   1,20,000.00	$   7,45,000.00
	Variable cost (Opportunity)=($200000*40%)
13)	Residual Income=($230000-$745000*15%)	$   1,18,250.00
14)		Last Year
	Sales	$ 10,00,000.00
	Less: Variable Cost	$   3,00,000.00
	Contribution Margin	$   7,00,000.00
	Less: Fixed Cost	$   5,00,000.00
	Net Operating Income	$   2,00,000.00
	Average operating assets	$   6,25,000.00
14)	Residual Income of Last year=($200000-$625000*15%)	$   1,06,250.00
	Increase Residual Income=($118250-106250)	$      12,000.00
	Yes Westerville's chief executive would pursue the investment opportunity.
15)		Residual Income
		Last Year	Investment Opportunity	Total
	Sales	$ 10,00,000.00	$   2,00,000.00	$ 12,00,000.00
	Less: Variable Cost	$   3,00,000.00	$   1,00,000.00	$   4,00,000.00
	Contribution Margin	$   7,00,000.00	$   1,00,000.00	$   8,00,000.00
	Less: Fixed Cost	$   5,00,000.00	$      90,000.00	$   5,90,000.00
	Net Operating Income	$   2,00,000.00	$      10,000.00	$   2,10,000.00
	Average operating assets	$   6,25,000.00	$      80,000.00	$   7,05,000.00
	Variable cost (Investment Opportunity)=($200000*50%)
	Residual Income of previous year calculated in 14 above	$   1,06,250.00
	Residual Income=($210000-$705000*15%)	$   1,04,250.00
a)	Reduce Residual Income	$        2,000.00
	Residual Income is lower than the residual income from previous year, so Westerville's chief executive would not pursue the investment opportunity
b)	The Chief executive officer of the company does not want to pursue the investment opportunity because net operating income is below the minimum required rate of return.
	Investment Opportunity	$   1,20,000.00
	Net Operating Income	$      10,000.00
	Minimum required rate of return=($120000*15%)	$      18,000.00
	Residual Income	$      -8,000.00